In the financial markets, commodities represent a unique asset class with returns driven by factors distinct from traditional equities and bonds. In their seminal paper, “The Fundamentals of Commodity Futures Returns,” authors Gary B. Gorton, Fumio Hayashi, and K. Geert Rouwenhorst investigate the fundamental determinants of commodity futures returns. Their research aims to provide a deeper understanding of how physical market conditions, particularly inventory levels, influence futures prices and risk premiums.

Grounded in the Theory of Storage, the authors hypothesize a direct relationship between commodity inventories and the shape of the futures curve, or basis—the difference between futures prices and spot prices. According to the theory, low inventory levels should lead to backwardation (a positive basis where futures prices are below spot prices), indicating higher expected returns for holding futures contracts. Conversely, high inventory levels should result in contango (a negative basis where futures prices are above spot prices), suggesting lower expected returns.

To empirically test this relationship, Gorton, Hayashi, and Rouwenhorst assemble a comprehensive dataset spanning 31 commodity futures and their corresponding physical inventories over a 37-year period from 1969 to 2006. This extensive dataset allows for a robust examination of the Theory of Storage across a diverse range of commodities and market conditions.

The authors’ analysis reveals a significant correlation between inventory levels, the basis, and futures returns. Their findings are encapsulated in key figures that illustrate the strength of these relationships.

The figure plots the sample average basis against the sample average futures excess return for individual commodity futures between December 1990 and December 2006. The basis is measured as the relative price difference between the two closest-to-maturity contracts, expressed as a percent per annum.

This scatter plot demonstrates a clear positive relationship between the average basis and average excess returns of commodity futures. Commodities with a higher average basis tend to exhibit higher excess returns, supporting the notion that backwardation, associated with low inventories, leads to higher expected returns.

For each commodity, the sample is divided into months when actual inventories relative to normalized levels are above unity (High) and below unity (Low). Panel A plots the average basis deviations from the full sample mean during High and Low inventory months. Panel B shows the prior 12-month futures returns deviations from the annualized sample average during these periods. The t-statistics for the difference between High and Low inventory months are indicated in red.

Figure 2 further reinforces the Theory of Storage. Panel A illustrates that during periods of high inventories, commodities consistently exhibit negative deviations from the average basis (contango), while low inventory periods correspond to positive deviations (backwardation). Panel B shows a similar pattern for prior 12-month futures returns, with low inventory periods associated with higher returns. The statistical significance of these differences underscores the impact of inventory levels on futures returns.

The insights from this study have significant implications for investors employing return stacking strategies, which aim to enhance diversification and returns by layering multiple return streams in a capital-efficient manner. Understanding the relationship between commodity inventories, the basis, and futures returns enables investors to make more informed allocation decisions within these strategies.

During periods of low inventories, when commodities exhibit backwardation and higher expected returns, investors might consider increasing exposure to commodity futures to capture the positive carry or futures yield. This approach aligns with the principles of portable alpha, where investors seek to add uncorrelated sources of alpha to their portfolios without significantly altering their risk profiles.

Conversely, in high inventory environments characterized by contango and lower expected returns, return stacking strategies might reduce commodity exposure or focus on commodities less affected by storage dynamics. Additionally, incorporating trend following strategies can be beneficial, as they adapt to changing market conditions and can exploit momentum across various asset classes, including commodities.

By integrating these insights, investors can enhance their portfolio construction, achieving greater diversification and potentially improving risk-adjusted returns through capital-efficient allocations to commodity futures within a return stacking framework.

Gorton, Hayashi, and Rouwenhorst’s research provides compelling evidence that commodity futures returns are fundamentally linked to physical market conditions, specifically inventory levels. Their empirical findings validate the Theory of Storage, demonstrating that the basis and prior returns are strong indicators of inventory scarcity or abundance, which in turn influence futures returns.

For investors utilizing return stacking strategies, these insights highlight the importance of monitoring commodity inventory levels and market structures. By aligning commodity futures exposures with periods of favorable carry and expected returns, and by employing strategies like portable alpha and trend following, investors can enhance portfolio diversification and capital efficiency.

Understanding the fundamental drivers of commodity returns enables more strategic allocation decisions, contributing to more robust and resilient investment portfolios.